Passive Investors and Other Endangered Species

Passive investing is fine in theory, but extremely difficult to apply in the real world.

By Todd Bliman, 10/25/2013

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Maybe I’m overly purist, but just as you can’t be a little bit pregnant, you can’t be a partially passive investor. Owning a passive product does not a passive investor make.

Let’s review. In a passive investing strategy, the investor purchases a fund designed to mimic an index and holds it, theoretically, forever—come hell or high water. Effectively, the school of thought advocating this approach presumes liquid markets (stocks, bonds, etc.) are simply too rational and efficient to beat over the long term. Hence, trying is fruitless. Investors are better off with a return only slightly behind an index’s long-term return.

So, advocates say, buy an index fund, set it and make like Rip van Winkle.

Passive investments are, of course, common. Such mutual funds and exchange-traded funds (ETFs, the vast majority of which invest passively) dot any list of the world’s most-owned fund investments. For this reason, folks seemingly presume passive investing is commonplace. Easy. Everyone’s doing it. It’s in the pages of the financial pressnearly daily, and it’s next to impossible to avoid a discussion in the personal finance section of your favorite news source.

Buying passive products is easy, of course. But so is selling them! So easy many investors can’t help but do so. Simply buying a product that mirrors an index doesn’t make an investor passive—passive investing is all about discipline. Extreme discipline requiring a coolly rational ability to properly define your goals. Then select an asset allocation likely to reach those goals. And the gumption to veer from this allocation only when life events or changing goals necessitate a long-term allocation change. That means never veering from the selected index fund out of fear or greed. Shifting at other points is an active choice. The number of investors who can successfully pull this off is miniscule. And failure at any of these steps may greatly hamper your ability to reach your financial goals.

The decision to use index funds comes only after you’ve decided on what type of index fund to seek. How you reach this decision is crucial—first, you must successfully and clearly identify your goals and objectives. Then select a mix of stocks, bonds and other investments likely to reach those goals. That’s true of both passive and active investing—and this decision accounts for many investor failures. Numerous studies have found this single decision determines the majority of an investor’s return—and index funds offer no help here.

Moreover, many folks who claim passivity buy multiple funds—seeking to fill out what the industry calls a “style box” (example here) or other mechanical means of “diversifying.” But this further reduces the impact of indexing. The asset and sub-asset allocation decisions are being made by a potentially inefficient means—the investor choosing. (That’s an active decision if you’re keeping score.)

But let’s assume for a second you correctly allocate. And you mirror only stock or stock and bond indexes. You’re still not out of the woods. Above all, the biggest problem with passivity is the sheer emotional challenge. Most folks are insufficiently robotic to successfully weather all the market can throw at them. In his book, The Informed Investor, Frank Armstrong III documents a speech given by former Fidelity Magellan fund manager Peter Lynch, in which Lynch reportedly noted Magellan’s shareholders failed to achieve anything resembling the fund’s returns. Why? Constant emotion-driven flipping in and out. DALBAR, a market research firm, has documented much the same phenomenon for years in its Quantitative Analysis of Investor Behavior. This year’s DALBAR report showed average holding periods for fund investors were just 3.3 years—a piece of a piece of a market cycle (about half an average-length bull market). DALBAR states this isn’t long enough to allow investors to reap markets’ benefits. These issues aren’t limited to actively managed fund investors. To believe otherwise presumes passive investors have found the evolutionary on/off switch and toggled it sufficiently to mute emotional reactions to gain and loss. Seems a bit of a stretch.

And you shouldn’t allow hindsight bias to whitewash your actual thoughts. Want to truly test whether you can handle passive investing? Actively record your thoughts on markets day by day for years. In the end, you’ll have a sufficiently long time period to reflect on. Would you have abandoned a broad-based index fund in favor of dotcoms during 1999, when the Nasdaq outperformed the S&P 500 by 64 percentage points?i Would you have liquidated at some point during 2008-2009’s financial panic, when stocks had fallen roughly 60% from their peak? Would you have added in Emerging Markets holdings after their markets surged in the 2000s bull market? To successfully achieve the theoretical benefits of passive investing, you can’t make such calls and changes. They’re active decisions. (And if you have the stomach to actually stay cool through such wild periods in markets, you can probably do better in the long run applying that steely will in an active approach.)

Even some of passive investing’s best known proponents seemingly struggle. In a recent article published in The Wall Street Journal, Burton Malkiel—a strong advocate of index investing and author of A Random Walk Down Wall Street—admitted roughly 10% of his portfolio is invested actively in individual stocks. For fun! Now, read this carefully and slowly: Investing a small portion of your assets speculatively for fun is a-ok with me, but should you do so, you’re not being passive. Passive investing, again, is a discipline. Once that has broken, how long would it be for most folks before tweaking bleeds into their so-called serious money?

Similarly, recent winner of the Nobel prize for Economics, Eugene Fama—whose efficient market studies many claim as the intellectual foundation for passive investing—isn’t a passive investor. (Incidentally, Fama coined the “Random Walk” term Malkiel later popularized.)

If these two founders of Random Walk theory, two folks carved into passive investing’s Mount Rushmore, can’t or don’t do it, what’s the likelihood many individual investors can?